Price adjustments under fixed exchange rate, Microeconomics

Assignment Help:

PRICE ADJUSTMENTS UNDER FIXED EXCHANGE RATE:

In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.


Related Discussions:- Price adjustments under fixed exchange rate

Budget Line, if coast of good A fall by Rs.1 & coast of good B increases by...

if coast of good A fall by Rs.1 & coast of good B increases by 1 Rs. what will be the effect on budget line

What is average revenue and average revenue curve, What is average revenue ...

What is average revenue and average revenue curve Average Revenue:   The average revenue is the total revenue separated by the level of output. It is therefore the price.

Oparation research, discuss the significance of paration research

discuss the significance of paration research

Explain the factors which would affect the price of a good, Explain the fac...

Explain the factors which would affect the price of a good. As there is a very long list of determinants, the basic issue is for the student to describe and illustrate how shif

Marginal utility theory, discuss whether marginal utility is a realistic pi...

discuss whether marginal utility is a realistic piece of economy analysis in a consumer demand

International trade, compare and contrast adam smith''s theory of absolute ...

compare and contrast adam smith''s theory of absolute advantage theory and david ricardo''s comparative advantage theory of international trade.

Internal rate of return, If, for a specific project alternative, the discou...

If, for a specific project alternative, the discount rate equals the Internal Rate of Return, then the (discounted) Benefit Cost Ratio will equal unity (i.e., BCR=1.0). Define I

Economies of common services, Economies of Common Services: Through th...

Economies of Common Services: Through the concentration of firms in a particular industry in a given geographical location, the firms may enjoy certain commonservices.These

Business meeting etiquette, Business Meeting Etiquette: Before meetings, th...

Business Meeting Etiquette: Before meetings, the correct way to arrange a meeting is to take an appointment 3 to 4 weeks before, even though it is known that generally gatherings w

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd